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Morningstar | ANZ's 3Q18 Update Boosted by Strong Asset Quality, But Loan Growth Slowing. FVE AUD 30 Unchanged

Wide-moat Australian and New Zealand Banking Group's third-quarter fiscal 2018 update focused on capital, funding, asset growth and asset quality, with no news on earnings. The four operating drivers of loan growth, net interest margins, expense growth and bad debts are broadly in line with our expectations, underpinning our AUD 30 per share valuation. At current prices, the stock is fairly valued, after increasing 13% since mid-June. We like the strong capital position, stable risk-weighted assets and sound asset quality. ANZ Bank also has quite a low level of lending to higher risk residential investors and interest-only borrowers. A key takeaway from the update is the bank's credit growth continues to slow. Factors are tighter credit conditions, higher regulatory mortgage risk weights and very competitive operating conditions particularly for high-quality owner-occupier home loans.

Despite softer loan growth in the quarter, ANZ Bank is steadily progressing corporate initiatives. These include disposing of noncore assets, growing capital levels, building the profitable Australian and New Zealand businesses, and most importantly, continuing to benefit from improved asset quality. The on-market share buyback program was recently doubled to AUD 3 billion and to date approximately AUD 1.5 billion has been completed.

The lower-than-expected bad debt expense for the quarter and ongoing pressure on NIMs results in minor changes to our fiscal 2018 cash profit forecasts. We reduce our bad debt expense forecast to AUD 800 million from the prior AUD 1.0 billion and partially offset a minor decrease in second-half NIMs to 1.91% from 1.93% previously. The net effect increases our fiscal 2018 cash profit forecast modestly to AUD 6.88 billion. Our fully franked dividend forecast of AUD 1.60 per share is unchanged with our fiscal 2018 dividend payout of 67% trending towards the bank's medium-term target of 60%-65% of cash earnings by end fiscal 2022.

ANZ Bank highlighted changing dynamics in the home loan market, noting the combined impact of regulatory changes and bank-initiated tightening during the past three years has meaningfully reduced average maximum borrowing capacity. An emerging trend is residential borrowers are increasingly turning to nonbank lenders where the two-year loan growth is estimated at 28% versus 11% for banks. However, bank lending is off a very large base and nonbank lending is off a very small base. The rapid growth in the less regulated nonbank sector could end badly when, or if, the financial system experiences the next liquidity crisis, similar to the 2007 event experienced in the early stages of the global financial crisis that resulted in many nonbank lenders exiting the sector.

The standout from the brief update was the reduction in bad debts to only AUD 121 million for the quarter, significantly lower than the average of the past few years. The annualised year-to-date loan loss rate is a low 0.12%, but we expect a seasonally higher fourth quarter and now forecast a full-year fiscal 2018 loss rate of 0.14%. We expect the bank's fiscal 2018 loss rate will be the equal-lowest for 12 years if achieved.

ANZ Bank's Australian home loans in the June quarter grew at a very subdued 0.38 times the system growth rate, reflecting the bank's focus on selected property areas, stricter lending criteria, and ongoing competition in the industry. NIMs were not released, but we expect margins to remain soft in the fourth quarter due to slowing credit growth, the recent cut in a key variable home loan interest rate, and elevated short-term funding costs. Lower margins were expected for the quarter considering elevated 90-day bank bill swap, or BBSW, rates to the overnight indexed swap rate, or OIS, spreads during the past several months. Peer Commonwealth Bank of Australia reported a two-basis point decline in margins to 2.14% for the six months ended June 30, 2018.

Australian Prudential Regulation Authority's, or APRA’s macroprudential limits were comfortably managed in the quarter with residential interest only lending down to 13% of total new residential lending, well within the maximum 30% limit. A total of AUD 6.5 billion of interest-only loans (customer initiated and contractual) switched to principal and interest in the quarter, compared with AUD 9.5 billion in fourth-quarter fiscal 2017 and AUD 6.8 billion per quarter on average for the three previous quarters. For the June quarter, ANZ Bank reported owner-occupied residential home loan growth of 4.4% annualised while investment home loan declined 2.5% annualised.

ANZ Bank's group mortgage 90 plus days past due loan arrears edged up modestly to a still-low 0.63% of total home loans from 0.62% at March 31, 2018, and 0.55% at March 31, 2017. Australian home loan delinquencies remained flat with investor loans slightly higher than owner-occupied loans. Group gross impaired assets improved, declining 7.7% to AUD 1.88 billion at June 30, 2018, compared with AUD 2.03 billion end March 2018. Consistent with peers, there are some pockets of mortgage stress, primarily in Western Australia, and more particularly in Perth.

Capital, liquidity, and funding ratios remain strong and well above regulatory minimums. The common equity Tier 1 capital ratio increased three basis points during the quarter to a very strong 11.07% at June 30, 2018, supported by 0.7% from One Path Life Reinsurance proceeds and organic capital generation, partially offset by 0.08% for the share buyback and a 0.59% deduction for the fiscal 2018 interim dividend payment. The capital ratio is equivalent to approximately 11.5% on a pro forma basis when announced asset sales settle and the additional AUD 1.5 billion share buyback announced in June 2018 are included. The bank has already met APRA's "unquestionably strong" benchmark capital ratio of 10.5% required by January 2020. The share buyback is designed to partially offset the steady and orderly build up in capital during calendar 2018. The stock is currently trading at an attractive dividend yield of 5.5% or 7.9% on a grossed-up basis.